AP Macro Phillips Curve, Monetary Policy

The Phillips Curve

(hypothetical example)

tt%

u%

PC

4%

2%

7% 5%

.

. . .

.

. .

Note: Inflation Expectations are held constant

The Phillips Curve

• In a 1958 paper, New Zealand born economist,

A.W. Phillips published the results of his research

on the historical relationship between the

unemployment rate (u%) and the rate of inflation

(tt%) in Great Britain.

• His research indicated a stable inverse

relationship between the u% and the tt%. As u%↓,

tt%↑ ; and as u%↑, tt%↓.

• The implication of this relationship was that policy

makers could exploit the trade-off and reduce u%

at the cost of increased tt%.

Trouble for the Phillips Curve

• In the 1970’s the U.S. experienced concurrent high

u% & tt%, = stagflation.

• 1976 American Nobel Prize economist Milton

Friedman saw stagflation as disproof of the stable

PC.

• Instead of a trade-off between u% & tt%,

Friedman and 2006 Nobel Prize recipient Edmund

Phelps believed that Un was independent of the

tt%. This independent relationship is now referred to as the Long-Run Phillips Curve.

1970’s Phillips Curve

π%

u%

PC

4%

2%

7% 5%

.

. . .

.

. .

. .

. .

.

.

. .

The Long-Run Phillips Curve

π%

u%

LRPC

un%

Note: Natural rate of unemployment is held constant

Un defined

The natural rate of unemployment (NRU) is defined as the equilibrium

rate of unemployment i.e. the rate of unemployment where real wages

have found their free market level

It is where the aggregate supply of labor is in balance with the

aggregate demand for labor.

At the natural rate, all those wanting to work at the prevailing real wage

rate have found employment and there is no involuntary unemployment

There remains some voluntary unemployment as some people remain

out of a job searching for work offering higher real wages or better

conditions.

The Long-Run Phillips Curve (LRPC)

• b/c the LRPC exists at the un, structural changes

in the economy that affect un will also cause the

LRPC to shift.

• In order to reduce the Un, structural policies

must be directed towards an economy's supply

side.

• Increases in un will shift LRPC

• Decreases in un will shift LRPC

Phillips Curve – LR and SR

Inflation

rate

LRPC

Unemployment

rate

SRPC (assumes 4 % expected inflation at each UR)

Natural rate

of

unemployment

2%

4%

SRPC (assumes 2% expected inflation at each UR)

Summary • There is a short-run trade off between u% & π%. This is

referred to as a short-run Phillips Curve (SRPC)

• In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)

• The LRPC exists at the natural rate of unemployment (un). – un ↑ .: LRPC

– un ↓ .: LRPC

• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC – AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC

– AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

• Δ Inflationary Expectations, Δ Input Prices, Δ Productivity,

Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC – SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC

– SRAS .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC

SRPC (tt^ %)

LRPC

tt %

uN%

A

B C

tt1 %

u%

SRPC (tt1^ %)

In the long-run, the inflation rate at B (π1 %)

becomes the new expected

inflation rate (π1^%), and the

economy returns to the

natural rate of unemployment

(point C).

Reconciling the LRPC and SRPC

tt%

u%

Assume that either

the government or

the central bank

enacts an

expansionary policy to reduce

the

unemployment

rate below its

natural rate at

point A.

In the short-run,

assuming the

policy is

successful,

inflation occurs

and

unemployment

decreases as

the economy

moves from A

to B.

SRPC (π^ %)

LRPC

π %

uN%

A

B C π1 %

u%

SRPC (π1^ %)

In the long-run, the inflation rate at B (π1 %)

becomes the new expected

inflation rate (π1^%), and the

economy, once again,

returns to the natural rate of

unemployment (point C).

Reconciling the LRPC and SRPC

π%

u%

Now assume that

either the government

or the central bank

enacts a

Contractionary policy to reduce

inflation from it’s

current rate at point A

In the short-run, assuming the

policy is successful, disinflation

occurs and unemployment

increases as the economy

moves from A to B.

Relating Phillips Curve to

AS/AD • Changes in the AS/AD model can also be seen in

the Phillips Curves

• An easy way to understand how changes in the AS/AD model affect the Phillips Curve is to think of the two sets of graphs as mirror images.

• NOTE: The 2 models are not equivalent. The AS/AD model is static, but the Phillips Curve includes change over time. Whereas AS/AD shows one time changes in the price-level as inflation or deflation, The Phillips curve illustrates continuous change in the price-level as either increased inflation or disinflation.

Increase in AD = Up/left

movement along SRPC

C↑, IG↑, G↑ and/or XN↑ .: AD .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC

GDPR

PL

AD

SRAS LRAS

YF

P

Y

AD1

P1

SRPC

π

u

π%

u% un

π 1

. .

. .

Decrease in AD = Down/right

along SRPC

C↓, IG↓, G↓ and/or XN↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

AD1

P1

u%

π%

SRPC

un

π

u

π1

. . . .

SRAS = SRPC

Inflationary Expectations↓, Input Prices↓, Productivity↑,

Business Taxes↓, and/or Deregulation .: SRAS .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC (Disinflation)

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

SRAS1

P1

u%

π% SRPC

LRPC

un

π

u

SRPC1

π1

. . . .

SRAS = SRPC

Inflationary Expectations↑, Input Prices↑, Productivity↓,

Business Taxes↑, and/or Increased Regulation .: SRAS .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC (Stagflation)

GDPR

PL

AD

SRAS

LRAS

YF

P

Y1

SRAS1

P1

u%

π%

SRPC

LRPC

un

π

u1

SRPC1

π 1 . . . .

Phillips Curve Review

• SRAS increases = shift SRPC right

• SRAS decreases = shift SRPC left

• AD increases = movement up and left

• AD decreases = movement down and right

• Increases in un will shift LRPC

• Decreases in un will shift LRPC

Money Market

NIR

Q1 Q

MD

MS

i1

•MS – affected by actions of the

Federal Reserve

•MD –

•Transaction demand

determined by GDP

•Asset demand

determined by NIR